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Monday, August 9, 2010

Owning a Home vs. Renting

Moshe Milevsky thinks that many homeowners should have rented. In his book, Your Money Milestones, he makes many good points to support his conclusion. However, there is a compromise choice that may be better than either typical home ownership or renting.

One of Milevsky’s arguments comes down to a correlation between wage risk and the investment risk in owning a house. If a big local employer leaves town, people lose their jobs and at the same time see the value of their houses drop.

Another of Milevsky’s arguments is that houses represent too high a percentage of the typical homeowner’s net worth. Having all your money tied up in one house is similar to having your entire portfolio tied up in one stock.

Milevsky does discuss some of the benefits of home ownership. There can be social benefits to having stable neighbours who help each other. To this I would add the benefit of not having to interact with a landlord.

I don’t see this as a binary choice. A compromise that would help many people would be to own a smaller, less costly house. I see too many people who say that they need a bigger house, but their current house is full of junk they don’t use. Amassed stuff is clogging up their lives.

I’m not talking about the extreme cases of clutter dealt with in some television programs. I’m talking about the majority of people who make the parts of their house that others see fairly presentable, but have almost all storage space and maybe a room or two jammed up with useless junk. When baby comes, it may be a better idea to throw away junk instead of buying a bigger house.

If people limited their mortgage payments to say 20% of their income instead of the currently accepted limit of about 30%, they would look much better against Milevsky’s criticisms.

For those whose income is modest compared to the cost of houses in their chosen neighbourhoods, buying a less expensive house might not be an option. For these people, Milevsky makes a strong case for renting. When buying a less expensive house in an option, aspiring homeowners would do well to consider this option seriously.

11 comments:

I don't think renting vs buying is a good idea at all. A mortgage is not a bad thing to have and in my experience has been one of my best investments. The house I own has gone up considerably since I bought it. My current mortgage rate is 3.xx so pulling out money from there and placing it in an investment (even a bond fund) makes sense.

I will likely keep a mortgage right up to retirement then pay it off with the investment portion of my whole life insurance policy (which pays at least 5%). In times where rates go up I cut back on investing and put more on the mortgage principal as an investment with better return. I do the opposite when rates are low.

All the while I own my properly and control my investment future. A home is a good investment, a mortgage is a great one.

@Greg: If I can summarize your argument, it would be 1) you expect the value of your house to rise nicely, and 2) you like leverage because interest rates are low. There have been periods where houses have dropped in value. Leverage can be dangerous if your investments drop in value. For example, if interest rates rise, your bonds will drop in value. Things may work out well for you, but this is not guaranteed. As an aside, I'm always suspicious that whole life insurance policies have large embeeded costs.

Mortgaging the house is another compromise solution. That way, the portion of your net worth tied up is less than the value of the house. This would be the case if every month, you make your mortgage payment, but invest a similar amount in the market, increasing investment debt. Your total debt stays the same, but your net worth shifts to be more balanced between the house and liquid investments.

@Robert: Actually, the percentage of you net worth represented by the house does not change if you take out a mortgage. The bank is not your real estate investment partner. If the house goes up or down in value, you get all of the gain or loss. You may feel as though you only own a fraction of the house's value, but you are fully exposed to the volatility of the full value of the house.

The leverage has made it so that your total invested is more than 100% of your net worth. It may seem that your real estate exposure is less when you have a mortgage, but it is not. You have just added exposure to other asset classes as well. Your total risk is now higher than if you just owned the house.

I wonder if the rent vs. buy decision could also take into account valuation levels attached to houses, as measured by ratios such as house prices to rent, income, etc. Renting makes more sense when rents are low relative to house prices and vice versa, less sense when rents are quite high relative to prices.

I suppose it is true the bank is not your partner on real estate risk, though it could happen in a collapsing market. For instance, my brother is buying a short sale in Nevada. The seller needs to get his lender to agree to absorb the capital loss on the house. My brother's successful offer was 50% of the current owner's (maybe they should just be called the current occupant) purchase price five years ago.

Of course, this isn't a standard case, and our regulations in Canada are different.

I suppose the reason that houses have traditionally been a decent investment are what you've alluded to here: leverage and a steady rise in prices. This hides the real risk that a leveraged drop in prices tends to destroy equity rapidly, leading to the dire default risk that presently faces the American economy . The real mystery is why don't people with negative equity in their homes simply abandon them? I do think, however, that legions of owners (again, occupants) are halting their mortgage payments, since they don't fear forclosure. They may lose their homes, but they have no equity, no skin in the game. Also, since there is a glut of real estate on the market, banks are currently not keen to foreclose, so lucky borrowers may live mortgage-payment free in a home they don't really "own" (no equity)for quite a long time.

@Gene: It's true that the bank takes some real estate risk when it writes a mortgage, but not much compared to the homeowner. I know that some Americans have stopped making mortgage payments because they have negative equity, but is this happening in Canada too?

My question with the people walking away from homes is where exactly are they going to go? What right thinking landlord would rent to a potential tenant who walks away from its responsibilities?

Regardless, this is much harder to do in Canada than in the U.S. since the mortgagor is still responsible for the difference between monies owing and the sale proceeds on the home (at least in Ontario).

Yes, as Thicken mentions, and as my brother told me, in the US, collateral for a mortgage consists only of the house. In Canada, I think we are still liable for our debts even if we lose our home.

As far as renting to someone who has abandoned their home, maybe a landlord could require a more stringent rental agreement. Either that, or the renter would have to find someone willing to rent without a credit check.

Voluntarily having your home repossessed allows you more flexibility to move to a different state in search of better employment.

Politicians and bankers might appeal to an owner's moral code to make good on their debts, but in reality, financial institutions stop paying underwater mortgages all the time. They make a business decision to break the contract, and some argue homeowners should be allowed the same privilege.